SG CIB tries to fix variance swap flaws

Variance swaps have been popular among sophisticated investors such as hedge funds and bank prop desks in recent years. The products grant investors a payout equal to the difference between realised variance and a pre-agreed strike level, multiplied by the vega notional. Vega is the sensitivity of an option's price to changes in volatility.

As variance is the square of volatility, any increase in volatility can have a devastating effect on sellers of variance swaps. It was this scenario that unfolded in the months following the bankruptcy of Lehman Brothers in September last year.

To prevent runaway losses in future, SG CIB has come up with the so-called American variance swap. It gives sellers of variance the right to effectively step out of the trade on a monthly basis. If investors begin to worry about a future market crash, they can terminate the swap, paying out an amount based on the level of volatility realised during the period the trade was on.

"With the American variance swap, the client sells volatility in a safer way, by buying the right to step out of the trade if things go wrong. This way, the client sells volatility at a less attractive price but does not suffer from implied volatility if he decides to get out of the trade," said Stéphane Mattatia, Paris-based head of hedge fund engineering at the bank.

Alternatively, investors who are interested in going long realised volatility can sell SG CIB the ability to exit the trade - allowing them to express a view on the future direction of volatility at a discounted price.

Although options on variance are available, the American variance swap avoids the high premium associated with these products. "This product is a hybrid between the standard variance swap and options on variance. But because there is less volatility of volatility than on options on variance, it can be more easily traded," said Mattatia.

While he would not disclose the amount of interest the bank had seen in the product, he said the bank had conducted its first trade and was talking to clients on a one-to-one basis.

Last year's market turmoil left dealers with losses that some estimate in the hundreds of millions of dollars. Due to the idiosyncratic risks of single stocks, and the difficulties of hedging single-stock variance, banks involved in these products were particularly badly hit. While the payout of single-stock variance swaps is usually capped at 2.5 times the volatility strike level, this is a limit dealers now recognise to have been inadequate. Markets in single-stock variance remain extremely thin, while some banks have stopped quoting single-stock variance altogether.

Nonetheless, SG CIB is also looking at ways to similarly limit the risks of single-stock variance swaps. Corridor variance swaps are one solution proposed. These only pay out on realised variance while the price of the underlying remains within a given range or corridor. Depending on where this range was set, sellers of such instruments could have been insulated from some of the heavy losses taken last year.

Elsewhere, some dealers are now promoting volatility swaps as an alternative to variance swaps on single stocks. The products pay out volatility as opposed to variance, meaning they give a less juicy payout and are easier to risk-manage.